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Portfolio Strategy

Beware of these yield traps Add to ...

The thirst for yield at a time of low interest rates can make investors do crazy things.

Like buying high-yield bonds without understanding the significant risks. Or scooping up income trusts with double-digit yields, oddball corporate bonds, perpetual preferred shares and market-linked guaranteed investment certificates. If the income-producing investments you're most comfortable with are government bonds and regular GICs, then beware all these yield traps.

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High Yield Bonds High-yield bonds are a good place to start because they've been both hot and popular in the past year. These are bonds that are issued by companies that have weak financials and thus must offer higher interest rates than governments or blue-chip corporations. The drawback with high-yield bonds is that they behave more like stocks than conventional bonds. They'll do comparatively well when interest rates are rising, which is a definite plus, but they'll be annihilated in the kind of market downturn we saw in 2008-09. Some of the largest high-yield mutual funds lost 20 to almost 40 per cent in '08, for example. Cautious about stocks? Then high-yield bonds aren't a good place to find yield.

High-Yield Income Trusts Same for high-yielding income trusts, which we'll define here as anything paying much more than 12 to 15 per cent. When you see a yield this high on a trust, it tells you that investors have bid down the price in expectation of a distribution cut. This may be a result of problems in the underlying business, or the expectation that a trust will have to cut its payout when it converts to a corporation in preparation for the introduction next year of a new tax on trusts. Let Yellow Pages Income Fund serve as an example. Its yield in mid-February was 13.7 per cent, which suggests investors were expecting to receive less cash following a corporate conversion. Let's recall that Yellow Pages' yield got up to about 16 per cent in May, 2009, just before a 30-per-cent cut in the distribution.

Perpetual preferred shares Perpetual preferred shares pay dividends, but they're best thought of as something along the lines of a bond with no maturity date. Some preferred shares offer some certainty that after a set period of time, they will either be redeemed or have their dividend re-set to adjust to the current level of interest rates. Not perpetuals, though. The companies that issue them can certainly redeem them, but it's best not to hold out any hope of this happening. Without a firm redemption date, these shares tend to be extremely vulnerable to rising interest rates. A sharp run-up in rates would send prices sharply lower, which is bound to scare conservative income-seeking investors. That said, the dividends paid by these shares are as secure as the company issuing them. Given that most preferreds are issued by financial companies, the level of security can be said to be high.

Corporate bonds Beware oddball corporate bonds, too, if you're looking for yield. Scanning one particular online broker's inventory recently uncovered bonds issued by American International Group, Citigroup and the Bank of Scotland. All three of these companies were hammered in the global financial crisis, and that explains why their bonds were yielding 6 to 13 per cent. Avoid.

Market-Linked GIC One last yield-producing investment to avoid is the market-linked GIC, where returns are tied to a particular stock index or bundle of stocks. If the indexes or stocks do very well, you could end up making more than you would with a conventional GIC. The reason to avoid these GICs is that they're a much better money maker for the banks that sell them than for investors. Sure, you might make a better return than a straight GIC. But you could also end up with less, which means you're gambling.

Smarter bets if you're a conservative investor thirsty for yield: conventional GICs issued by an alternative financial institution offering higher than normal rates, blue-chip dividend stocks or bonds issues by financially strong corporations. Lower yields, yes, but less risk. You're better off that way.

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